Homebuilders Rise on a Shaky Foundation

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Over the past few years, the goal of builders has been to reduce the number of homes they build on speculation—without a signed contract—to avoid price wars with competitors. But in 2009, builders that didn't have a supply of spec homes available in October or early November saw their orders drop dramatically, because buyers needed homes that would be ready to close on by Nov. 30 in order to qualify for the tax credit, says Oppenheim.

That's one reason for D.R. Horton's better-than-expected earnings in the first quarter of fiscal 2010, since the company had the largest supply of spec homes, he adds.

This year, most builders are talking about erecting more spec homes in order to meet demand by buyers eager to take advantage of the extended tax credit, says Oppenheim. "Some builders don't want to build too many spec homes, but they will build and stop at the drywall stage, so buyers can still choose the finishes they want" to personalize their homes, he says. "Homes can be finished fairly quickly."

Most Attractive Shares

Oppenheim's top stock picks are KB Home (KBH), Lennar (LEN), and NVR (NVR), all of which he expects to benefit disproportionately from demand from first-time home buyers spurred by the tax credit. He upgraded NVR to outperform from neutral and raised his rating on D.R. Horton to neutral from underperform on Feb. 12.

KB Home's advantage is that roughly 80% of its customers are first-time buyers. To compete better against foreclosure sales in certain markets, the company is building smaller homes, hoping to push sales prices down close to those of foreclosures, says Oppenheim. While the tactic has generated some orders, new home construction overall is down sharply from where it was before the housing slump, due to competition from sales of existing homes, including foreclosures, he says.

Lennar has a fairly low price point, while 50% to 60% of NVR's exposure is in the mid-Atlantic area, which is still considered strong. NVR's market-share gains in that region will help boost its margins, he adds.

In the Phoenix metro market, one of those hardest hit by the downturn, home builders have shifted toward lower-priced homes. Builders are also making a big play to boost their market share in that market, according to Jim Belfiore, president of Belfiore Real Estate Consulting, a market research firm in Phoenix.

He sees companies such as Meritage Homes (MTH), Beazer (BZH), Lennar, Hovnanian (HOV), and KB Home aggressively buying up subdivisions now that a lot of small and midsize privately held builders have gone out of business due to bankruptcy or site foreclosures. Prices of lots in these subdivisions have been bid up aggressively in recent months, he says.

Keeping Their Names Visible

"Prices are phenomenally low. [A home buyer] can buy a $80,000 to $90,000 house brand new on the outskirts [of Phoenix]—1,000 to 1,200 square feet—and you haven't been able to do that in a very long time," says Belfiore.

Builders are saying they don't expect to turn a profit on any of the homes they build in these subdivisions in the first year, but the activity keeps their names visible in the market, which is important for gaining market share once the recovery comes.

The builders are more likely to be able to sell out their homes in new subdivisions in view of the plunge in the number of active new subdivisions in the metropolitan Phoenix area. The number fell to 414 at the end of 2009, from 1,250 in early 2006, when the housing decline began, says Belfiore.

"They're keeping their division people on board—division presidents and land acquisition personnel, the business people who run the operation," he says.

While the economic recovery holds out hope for homebuilders, the wild card will be the rate of foreclosures. And that's likely to become more volatile as the government withdraws its massive liquidity on signs that the economy is finding its footing again.

Bogoslaw is a reporter for Bloomberg BusinessWeek's Finance channel.

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